An 18-Month Devolution

Posted on January 8, 2013

“What began eighteen months ago as an effort to regain long-term fiscal sustainability devolved so completely that a last-minute accord was required to head off a very unfortunate economic outcome.” - Northern Trust

We find it interesting to look up the Google search trends on particular phrases from time to time. Doing so can reveal the sheer power that the media has to shift the public’s focus from one topic to the next. It can also reveal how important issues can remain unnoticed by the masses until just the last minute. The chart below reflects the trend in Google search traffic for the term “Fiscal Cliff” in 2012. As you can see the bulk of the traffic didn’t even start showing up until after Christmas! We’ve also highlighted the six instances when we wrote about the Fiscal Cliff in our weekly posts throughout the year. We obviously believed it to be an important issue for both the economy and markets for months leading up to the deadline, so at the risk of beating a dead horse we felt it necessary to enter yet another Cliff-related post reviewing the deal that was struck by Congress on new year’s day.

As mentioned in the Northern Trust quote above, this whole cliff issue really began roughly eighteen months ago with the Budget Control Act of 2011 (see our post Fiscal Cliff Diving). What started out as an effort to structurally change the long-term fiscal path of our country slowly devolved into the dysfunctional brinksmanship that we saw on display in late December.

The following chart breaks down the back-and-forth proposals between the White House and representative Boehner in the final weeks of the year. With each new proposal both sides seemed to be inching towards compromise, but at the end of the day the two were still too far apart to strike any sort of grand bargain.

Hours after the country had technically gone over the cliff an agreement was finally struck that addressed some, but not all, of the components. The following is a summary of what we consider to be the most important outcomes of the deal:

The Bush tax cuts were made permanent for the majority of payers, while some high wage earners will see an increase in their top marginal rates from 35% to 39.5%.

Dividend and capital gains tax rates are preserved for most payers, while some high wage earners will see rates climb to as high as 23.8%.

Payroll taxes revert back to 6.2% on the first $113,700 of income after being temporarily reduced to 4.2%.

The estate tax exemption of $5.12 million was permanently extended with annual inflation bumps. The top estate tax bracket increased from 35% to 40%.

Various tax relief measures that have been around since 2009 were extended for another five years, while emergency unemployment benefits were extended another one year.

Automatic spending sequesters were delayed for two months.

This deal side-stepped many of the tax increases that were slated to go into effect, thereby limiting the impact on private sector demand in the new year. The consensus seems to now be that the US economy, powered by housing and autos, will be able to take these changes in stride and avoid a recession.

But the real fireworks may yet be in store. In roughly two months’ time our newly elected congress will have to determine what to do about the $109 billion in spending sequestrations that were part of the original cliff, and at the same time they will be dealing with the issue that started this whole debate a year-and-a-half ago – raising the debt ceiling (see our post The Definition of a Bad Economist).

There is some speculation that Republicans caved on their demands for spending reductions in last Tuesday’s deal with the intention of revisiting these demands when the debt ceiling debate came back around. The thinking is that by threatening to oppose raising the debt ceiling (which would result in the US government defaulting on its obligations), perhaps the Republicans can force the Democrats into stiffer concessions on long-term entitlement spending.

Obama, for one, is signaling anything but the willingness to negotiate. Last Tuesday after the fiscal cliff deal was signed he made the following comment in his address,

“I will not have another debate with this Congress over whether or not they should pay the bills that they’ve already racked up through the laws that they passed.”

A senior administration official later added,

“It means that he won’t negotiate on it. He’s not entertaining offers about it. We’re not having meetings about it.”

Those are very strong words to go on record with, so it will be interesting to see if the President backs off this stance and to what extent. Unfortunately, until either side changes its tune America has every reason to expect another heated round of negotiations and brinksmanship over this issue. We could even find ourselves in another scenario where Congress is attempting to strike a deal at the very last minute while economic and capital market participants are left to wait on the sidelines in uncertainty. This would have definite short-term implications for investors as it would likely bring another bout of volatility while further weakening public confidence in our policy makers’ decision-making ability. In an upcoming post we will take a more thorough look at how the debt ceiling debate impacted the economy and capital markets last time around – and what the implications for our investment strategy might be today.

Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.

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